Canadian Investments Funds Course

Transcription

1 Unit 7: Taxation Welcome to Taxation. In this unit, you will learn about the Canadian tax system and how it works. You will then learn about the taxation of mutual funds and the tax treatment of various types of investment income. Remember that as a mutual fund representative, you are not expected to provide detailed tax counselling, nor will you be qualified to do so. Nevertheless, it is important for you to understand the fundamentals of taxation to best serve your clients. This unit takes approximately 1 hour and 45 minutes to complete. You will learn about the following topics: Canadian Tax System Mutual Funds and Taxes Capital Gains and Losses Personal Income Tax Mutual Fund Corporations To start with the first lesson, click Canadian Tax System on the table of contents. Lesson 1: Canadian Tax System Welcome to the Canadian Tax System lesson. In this lesson you will learn about the key elements that make up the Canadian tax system in order to provide guidance to your clients. This lesson takes 30 minutes to complete. By the end of this lesson, you will be able to do the following: describe the key elements of the Canadian tax system including the following: total versus taxable income tax deductions versus tax credits marginal and average tax rates federal and provincial tax rates How Canadians are Taxed Most adult Canadians pay income tax. It is the price we pay for living in a society where government provides many of the services that we have come to expect, from social welfare programs to the roads we drive on every day. There are two major components to our income tax system: federal tax provincial tax In all provinces except Québec, the federal government collects both federal and provincial income taxes IFSE Institute 1

2 Total, Net, and Taxable Income You can follow these directions to calculate your total, net, and taxable income: Total income Calculate the sum of income from all sources, including earnings from employment, professional activities and investments, as well as workers' compensation benefits and social assistance payments. Net income Subtract any allowable deductions in order to reduce the amount of income on which federal taxes are based. Individual Canadians are allowed deductions for a range of expenses, from childcare expenses to RRSP contributions. Once you have deducted these expenses, you arrive at your net income. Taxable income Subtract additional amounts, such as the deduction for non-capital losses, social assistance payments, and workers' compensation benefits, to arrive at taxable income. Basic federal tax Once you know your taxable income, you can determine the amount of federal tax before nonrefundable tax credits. You arrive at this figure by using formulas supplied with each year's income tax return form. In Canada, we use a progressive tax system to calculate our federal tax. From this amount you subtract various non-refundable tax credits allowed by the federal government to derive your basic federal tax. Total, Net, and Taxable Income Employment earnings +investment income +professional income +business income +all other income (i.e. WSIB benefits, social assistance payments, etc.) Total income - all deductions (RRSP contributions, childcare expense, etc.) Net income - additional deductions (non-capital losses, social assistance payments, workers' compensation benefits) Taxable Income Case Study: Yasmin Fattah Part One IFSE Institute

3 Deductions vs. Credits Two ways to reduce the taxes on your tax return are to use: tax deductions tax credits Let's examine each one and compare how they affect your overall tax payable. Tax Deductions A tax deduction reduces the amount of income on which you pay taxes. It is deducted from your total income before the federal and provincial tax rates are applied. The most common deductions are RRSP and pension contributions, childcare expenses, moving expenses, and eligible employmentrelated expenses. In general, to see how much tax you save from a deduction, you multiply the deduction by your (marginal tax rate) MTR. Therefore, the bigger the MTR, the more you save from a tax deduction. Arun's MTR is 41.70%. He makes a $5,000 contribution to his RRSP, for which he receives a tax deduction. Assuming this does not reduce his taxable income to a lower federal or provincial tax bracket, he will reduce his taxes by $2,085 calculated as (the contribution MTR) or ($5, %). Tax Credits A tax credit reduces your amount of tax payable. It is applied after all deductions have been made and the federal and provincial tax rates have been applied, resulting in total tax payable. There are two types of tax credits. refundable non-refundable Refundable credits may be claimed no matter what your tax payable is. In other words, it not only reduces your taxes payable but may even generate a tax refund. The only refundable credit that ordinary taxpayers will encounter is the GST tax credit. Terence has $200 in taxes owing and a refundable tax credit of $500. He will receive a $300 refund from CRA, calculated as ($200 - $500). Non-refundable tax credits may only be used against taxes payable and only to the extent they reduce the amount of tax owing to $0. Celine calculates that she owes $400 in tax. She also has a $300 tax credit due to her tuition costs. Using the tax credit, Celine would reduce her tax owing to $100, calculated as ($400 - $300). If Celine has $100 in taxes owing and a $300 non-refundable credit due to her charitable donations, she will be able to use the tax credit to reduce her taxes owing to $0. However, she cannot create a refund using a non-refundable tax credit. Therefore, the unused $200 in credits will be lost. Common federal non-refundable tax credits arise from: charitable donations medical expenses tuition fees Canada Pension Plan contributions pension income dependent minor children 2010 IFSE Institute 3

4 Comparing Deductions and Credits The following table compares a $5,000 tax deduction with a $5,000 tax credit. Assume that a taxpayer has an income of $100,000 and pays tax at a rate of 40%. Deduction Tax Credit Income $100,000 $100,000 Tax Deduction ($5,000) n/a Taxable Income $95,000 $100,000 40% $38,000 $40,000 Tax credit n/a ($5,000) Tax payable $38,000 35,000 From this comparison, we can see that a $5,000 tax credit reduces our tax payable more than a $5,000 deduction. The example above is highly simplified to illustrate the difference between a tax credit and a tax deduction. Whether one is more advantageous than the other will depend on an individual's own situation. For instance, if you make a large RRSP contribution, the resulting tax deduction could mean your net income is in a lower tax bracket. In this case, a tax deduction may be more advantageous than a tax credit. Exercise: Tax Credits Surtaxes and Provincial Tax Basic federal tax is the amount remaining after subtracting non-refundable tax credits. If applicable, you add federal surtaxes on top of this basic tax. Currently, there are no federal surtaxes in place. You then add your provincial taxes. All provinces in Canada calculate tax based on the federal progressive tax system. Each province designates the ranges and percentages and any surtaxes that are applicable. Once you make all these calculations, you arrive at the amount of taxes owing for the year. You then subtract this amount from the taxes paid throughout the year to arrive at any additional amounts owed by you, or the refund owed to you. Income Tax Rates Although the basic procedure for determining income taxes is the same for all individuals, not everyone pays taxes at the same rate. Under Canada's progressive tax system, the higher an individual's taxable income, the higher the percentage of tax that is applied on portions of that income. To view current and historical income tax rates, click here to view the Canada Revenue Agency (CRA) Web site. When an individual moves into a higher tax bracket, only the income that falls in that bracket is taxed at the higher rate. For example, assume the taxpayer lives in Ontario and has taxable income of $85,000 per year. Using 2010 tax rates: IFSE Institute

5 Federal Tax Payable On first $40,970 at 15% $6, On next $40,971 at 22% $9, On next $3,059 at 26% $ Total federal tax $15, Provincial Tax Payable On first $37,106 at 5.05% $1, On next $37,108 at 9.15% $3, On next $10,786 at 11.16% $1, Total provincial tax $6, Total Tax Payable federal tax + provincial tax ($15, $6,472.95) $22, Therefore, his or her total federal and provincial tax (not including any surtax) would be $22, Federal and Provincial Sites for Tax Rates Tax legislation is subject to change. To stay informed, you can review federal and provincial budget changes on the following websites. Case Study: Yasmin Fattah Part Two Marginal Tax Rates As a mutual fund representative, you should be familiar with the concepts of average and marginal tax rates. Understanding the tax implications for your clients helps you advise them on their mutual fund investment strategy. Average tax rate The average tax rate can be calculated by dividing total tax payable by either the total income, net income, or taxable income for that year. Marginal tax rate The marginal tax rate is the rate of tax an individual pays on the last dollar earned. In other words, it is the highest rate at which earnings are taxed. When making investment decisions, marginal tax rates are more useful than average tax rates since we want to know what the tax implications would be from an investment. Omar is in the highest tax bracket in his province. He has a marginal tax rate of 43.70%, calculated as (federal 29% + provincial 14.7%). Therefore, for every additional $1 he earns, he pays almost $0.44 ($0.437) in tax. The marginal tax rate is also the rate at which the individual saves on taxes when taxable income is reduced. Maximum federal/provincial tax rates are based on a top marginal rate. To be taxed at this level, you must have enough taxable earnings to put you in the highest tax bracket. In Omar's province, you must have $120,888 or more in taxable income before any of your income is taxed at the highest rate. Income below that level is taxed at lower rates. In Laurent's province, you pay $0.44 in tax on your last dollar earned. However, if you are in the middle tax bracket, your combined federal/provincial taxes on the last dollar of income earned is much lower IFSE Institute 5

6 Case Study: Yasmin Fattah Part Three Exercise: Canadian Tax Lesson 2: Mutual Funds and Taxes Welcome to the Mutual Funds and Taxes lesson. In this lesson, you will learn about the income tax implications for both mutual funds and their investors. This lesson gives you an overview of the tax system and its consequences. Remember that as a mutual fund representative, you are not expected to provide detailed tax counselling, nor will you be qualified to do so. When such advice is called for, refer your client to a chartered accountant or other tax professional. This lesson takes 30 minutes to complete. By the end of this lesson, you will be able to do the following: explain how mutual funds are taxed describe the tax treatment on interest income for an individual investor describe the tax treatment on Canadian dividend income for an individual investor describe the tax treatment on foreign income for an individual investor Taxation of Mutual Fund Trusts While mutual fund trusts and mutual fund corporations both share similar objectives, they are structured differently and subject to different tax regulations. However, from the individual investor's point of view, their taxation is not affected by the mutual fund structure. In general, a mutual fund trust distributes its income and/or capital gains to its unitholders. Unitholders have to declare this distribution as income for tax purposes, regardless of whether the distribution is received as cash, reinvested, or applied toward the payment of fees owed by the unitholder. Any amount not distributed during the calendar year will be taxed in the hands of the fund at the highest federal rate applicable to individuals; by law, mutual fund trusts must use December 31 as their year end for tax purposes. Provincial taxes and surcharges are then added. However, in most cases the declarations of trust that govern most mutual fund trusts require the fund to distribute all net income and net realized capital gains to unitholders. Types of Income The income earned by a mutual fund trust and subsequently passed along to investors generally consists of one or more of the following: dividends from Canadian corporations interest income foreign income capital gains Each mutual fund must designate the income passed along to investors according to the type of income earned by the fund's investments. For example, if the fund realizes net capital gains from the sales of securities, that income must be designated as net capital gains in the hands of unitholders. T3 tax slips are mailed to unitholders on or before March 31 informing them of the amounts of each type of income received. Investors living in Canada must then report the income on their annual income tax returns IFSE Institute

7 Note: The tax procedure remains the same even if the individual holds the investment directly (outside of a mutual fund). Furthermore, the explanations that follow are based on the assumption that investments are held in non-registered accounts. Exercise: Types of Income Dividends from Canadian Corporations Dividends represent the after-tax portion of a company's profits paid to shareholders. Mutual fund investors often receive dividends from the distributions of mutual funds that invest in stocks. You must include dividends as part of your income for tax purposes in the year in which they are received. Individual Canadians get a tax break on dividend income received from Canadian corporations, or passed along by mutual funds. This tax break minimizes double taxation since dividends have already been taxed at the corporation level. Dividend gross-up and credit mechanism The income tax procedure for dividends is called the gross-up and credit mechanism. For dividends received from most mutual fund companies, first, you gross up the amount of dividends received. This grossed-up amount is listed as part of your taxable income. After you calculate your federal tax, a dividend tax credit of the grossed-up amount is deducted from your tax payable. The gross-up and resulting tax credit depends on the year in which it is received. Why the gross up? Federal Dividend Tax Credit (DTC) Gross-up 44% 41% 38% DTC as % of grossed-up dividends 17.97% 16.44% 15.02% The increased amount is designed to represent the taxpayer's portion of the total before-tax income that the corporation is presumed to have earned. The dividend tax credit is used to offset the portion of the tax that the corporation is presumed to have paid. In most cases, mutual fund investors don't have to figure out their taxable dividends or dividend tax credits. These figures appear on the T3 slips in Box 32 and 39, respectively. Note: There is no income tax provision for making use of the unused portion of the dividend tax credit in a previous or future year. Any portion of the credit not used in the year in which dividends are received is wasted. Dividends from non-resident corporations Dividends received from non-resident corporations (i.e., corporations that do not have to pay Canadian income tax) are not eligible for the dividend gross-up and tax credit scheme. Instead, these dividends are fully taxable and must be included as foreign-sourced income. Exercise: Dividends from Canadian Corporations 2010 IFSE Institute 7

8 Dividends: Sample Calculations Assume you receive $100 in eligible dividends from your mutual fund company and you are in the highest tax bracket. Assumptions Year 2010 Federal tax rate 29.00% Federal dividend tax credit 17.97% Provincial tax rate 11.16% Provincial dividend tax credit 6.40% Calculation of tax Dividend received $ Taxable dividend - gross up ($100 x 144%) $ Federal income tax ($144 x 29%) $41.76 Less dividend tax credit ($144 x 17.97%) ($25.88) Net federal income tax on $100 dividend $15.88 Provincial tax ($144 x 11.16%) $16.07 Less provincial dividend tax credit ($144 x 6.40%) ($9.22) Net provincial tax on $100 dividend $6.85 Total tax payable (provincial + federal) $22.73 In this case, the average effective tax rate on eligible dividends is approximately 23%. This amount varies according to a taxpayer's marginal tax rate and the income tax rate of the province in which he or she resides. Note: The provincial income tax rate and dividend tax credit are dependent on the taxpayer's province of residence. Furthermore, Québec residents are able to deduct a federal abatement from their federal tax payable. Exercise: Calculating the Dividend Gross-up and Tax Credit Interest Income When a fund distributes interest income to unitholders, tax consequences are more severe than those for dividend income. Interest income is fully taxed at the investor's top marginal tax rate. Interest is a pre-tax expense for the issuer/borrower so the investor bears the entire tax burden, unlike the situation with dividends. For tax purposes, interest income is classified as other income, which is reported in Box 26 of the T3 slip. At the end of the year, Rania received a T3 slip from her mutual fund company. It indicated that over the year, her distributions in the form of interest totaled $450. Rania's combined marginal tax rate (MTR) is 44%. Interest income does not receive any favorable tax treatment so Rania will have to pay $198 in tax on her distribution, calculated as (interest x MTR) or ($450 x 44%). Foreign Income Foreign income generally consists of dividends and interest from foreign sources. Both are fully taxable. For income tax purposes, interest and dividends paid by mutual funds from foreign sources are combined. They can be found in Box 25 of the T3 slip IFSE Institute

9 Foreign income is often subject to withholding tax levied by the country in which the income originates. However, the full amount of these earnings must be reported on a Canadian tax return. For example, the U.S.-Canada Tax Treaty, Articles X and XI, stipulates a 10% withholding tax on U.S. interest income, while the rate is 15% for U.S dividend income. Hence, $250 of interest income from the U.S. would be subject to $25 of withholding tax, leaving $225 in the hands of the Canadian recipient. However, the full $250 must be included in income for tax purposes. Each unitholder is entitled to claim a foreign tax credit or deduction for taxes paid to a foreign government by a mutual fund. In our example, the taxpayer would claim a foreign credit of $25. Any foreign taxes paid that are eligible for the foreign tax credit are reported in Box 34 of the T3 slip. For Canadian residents, the capital gains tax treatment is the same for foreign and domestic property. Although withholding tax is not applied to capital gains, you may be required to pay tax to the country where your investments are domiciled. Exercise: Interest and Foreign Income Lesson 3: Capital Gains and Losses Welcome to the Capital Gains and Losses lesson. In this lesson, you will learn about capital gains and capital losses in relation to mutual fund investments. You will learn about the components involved in calculating a capital gain or loss, as well as the tax treatment applicable to them. We will also touch briefly on taxation of corporate and non-resident investors. Remember that as a mutual fund representative, you are not expected to provide detailed tax counselling, nor will you be qualified to do so. When such advice is called for, refer your client to a chartered accountant or other tax professional. This lesson takes 45 minutes to complete. By the end of this lesson, you will be able to do the following: describe the tax treatment on capital gains for an individual investor describe the tax treatment on capital losses for an individual investor discuss the tax implications of a capital dividend describe the tax treatment on investment income for corporate unitholders describe the tax treatment on investment income for non-resident investors What is a Capital Gain or a Capital Loss? A capital gain results when assets are sold at a profit. Conversely, assets that are sold for less than their purchase price generate a capital loss. If assets have not been sold, then the capital gain or loss has not been realized. Unrealized capital gains or losses are not subject to tax. Undine purchased shares of a company for $2,000. The shares increased in value and she later sold them for $4,000. Because the shares appreciated in value, Undine realized a capital gain of $2,000, calculated as ($4,000 - $2,000). Frederick bought a rental property for $250,000. He was later forced to sell the property because he needed the funds to meet another obligation. As a result of rising interest rates, the real 2010 IFSE Institute 9

10 estate market had declined and Frederick was only able to sell his investment for $210,000. He incurred a capital loss of $40,000, calculated as ($210,000 - $250,000). Capital gains realized by individual investors are given preferential tax treatment. Only a percentage of capital gains (less any capital losses) are subject to tax. This number is called the inclusion rate. Currently the inclusion rate is 50%. After the inclusion rate is applied, the resulting amount is called taxable capital gain. It is on this amount that you apply the MTR. Charlie sold some mutual funds which resulted in a capital gain of $500. His taxable capital gain will be $250, or ($500 x 50%). If he has a marginal tax rate (MTR) of 30%, he will pay $75 in tax, or ($250 x 30%). Calculation of a Capital Gain or a Capital Loss A capital gain or capital loss is calculated as follows: To perform the calculation, you need to know three factors: adjusted cost base proceeds of disposition outlays and expenses Adjusted Cost Base (ACB) In its simplest form, the ACB is the purchase price. The ACB includes any eligible expenses, like commissions, associated with the purchase. Yoan purchased real estate at a price of $160,000 and paid $2,000 in legal fees as part of the transaction. The ACB of the real estate is $162,000, calculated as (purchase price + legal fees) or ($160,000 + $2,000). Sunil bought 1,000 shares of Fly By Night Corp. at $3 per share. He also paid a 5% commission to his broker for the purchase. The shares themselves cost $3,000 or (1,000 x $3), and the commission was $150 or ($3,000 x 5%). The ACB of Sunil's Fly By Night shares is $3,150, calculated as ($3,000 + $150). Identical properties and ACB Identical properties are capital assets such as the same stock or units of the same mutual fund. The ACB is calculated on a weighted average basis. Liam purchased his first 100 units of Newjack Dividend Fund in 2005 at a cost of $25 per unit. At that time, his average ACB was $25, calculated as [(number of units x NAVPS) number of units] or [(100 x $25) 100]. Liam bought another 200 units of Newjack in 2006 at a cost of $26 per unit and an additional 150 units in 2007 at a cost of $28 per unit. As a result of these subsequent purchases of identical properties, the average ACB of Liam's holding of Newjack is now $26.44, calculated [total investment total units purchased] or [((100 $25) + (200 $26) + (150 $28)) (( ))]. If Liam wishes to sell some of his units, it does not matter which ones he sells, because the units are identical properties. If he sells 200 units when the NAVPS is $30, he will realize a capital gain of IFSE Institute

11 $712, calculated as [(NAVPS - ACB) x units sold] or [($30 - $26.44) 200]. His remaining 250 units of Newjack would still have an ACB of $26.44 per unit because dispositions do not affect the average cost of identical properties. The average cost of an identical property is only affected by acquisitions. Mutual funds and ACB As mentioned above, a mutual fund's ACB per unit is calculated as an average price per unit from all purchases. Expenses (such as broker's commissions) that are related to the purchase of those units are included in the calculation. The ACB per unit is also affected by reinvestment of distributions. If the reinvestment price is higher than the original investment price, then the ACB per unit rises. Mutual fund investors who realize a capital gain (or loss) through a redemption receive a T5008 supplementary tax slip from the fund company. This slip shows the proceeds of the redemption, which are then used for calculating the applicable capital gain or loss. Proceeds of Disposition and Outlays and Expenses Proceeds of disposition The proceeds of disposition is the amount or fair market value (FMV) at which the asset is sold. You will also encounter the term, "deemed" proceeds of disposition. This is the amount that CRA assumes you receive, even though you don't actually sell the asset. You are taxed as if you do. Sally sold her house for $180,000. The proceeds of disposition are therefore $180,000. Harry gave 500 shares of TooGood Corporation to a friend as a wedding present. At the time of the gift, the shares were worth $375. Even though Harry did not actually receive anything from the transfer of the shares, he is deemed to have received proceeds of $375. Jessica owned 1,000 shares of One Little Victory Corporation. In 2007, Jessica died. For tax purposes, Jessica was deemed to have disposed of her shares. Outlays and expenses Eligible outlays and expenses are those payments that are associated with the sale of the asset, such as legal fees or commissions. Yoan bought 100 common shares at a price of $13 each, plus a commission of 2%. Her ACB for the shares is $1,326 or [(100 $13) (1 + 2%)]. Yoan's outlays and expenses of $26 incurred in the acquisition of the shares are part of the ACB of her shares. Yoan later sold those shares for $1,500, and she incurred another transaction charge of 2% or $30, calculated as ($1,500 2%). The proceeds of disposition from the sale of the shares are $1,500. Yoan's capital gain is $144, calculated as (FMV - ACB - outlays & expenses) or ($1,500 - $1,326 - $30). Yoan's outlays and expenses of $30 incurred from the sale of the shares are deducted from the proceeds of disposition when calculating the capital gain. They do not form part of the ACB of the shares. Mutual Funds and Capital Gains There are two ways capital gains can affect the tax position of mutual fund investors: distributions redemptions 2010 IFSE Institute 11

12 A fund can distribute capital gains made through the sale of property held by a fund. A portfolio manager purchases 10,000 shares of TUX Ltd. in January for $100,000. In October, the portfolio manager sells all the shares for $150,000. In December, he or she distributes the $50,000 capital gain to unitholders, calculated as ($150,000 - $100,000). Alternatively, the investor can realize capital gains (less any capital losses) when fund units are redeemed for more than their cost. An investor purchases $5,000 of Canadian Equity Fund in January. In December, the investor sells the mutual fund for $6,000. From the sale, the investor has a capital gain of $1,000, calculated as ($6,000 - $5,000). Capital Gains through Distributions When an investor receives a portion of net capital gains (total capital gains during the year, less any capital losses) through distributions made by a fund, these amounts are taxable. Earlier this year, the fund manager for Equinox Canadian Equity Fund sold some shares in the portfolio and realized a capital gain. At year-end, he distributes this gain to unitholders. One of the fund's unitholders, Lionel, receives a capital gain distribution of $500. Lionel calculates his taxable capital gain as $250 or ($500 x 50%), which he reports on his tax return as part of his taxable income. This amount is reported in Box 21 of the T3 slip. Net capital losses by a fund are not distributed, but under tax legislation they may be carried forward indefinitely. The net capital losses may also be carried back three years to reduce capital gains realized by the fund in other years. In reality, the capital losses of a fund are never carried back because all capital gains have presumably been distributed to investors. Year-end Tax Trap In some cases, you can incur an unnecessary tax liability by purchasing a mutual fund towards the end of the year. Although income distributions can occur throughout the year, most mutual funds distribute their capital gains and income in December. All registered unitholders that own a fund before the exdividend date receive the distribution. If you purchase a mutual fund just before the ex-dividend date, you have a tax liability for that year even though the total value of your holdings is the same as before the distribution. On December 30, Sam invested $1,000 in a no-load mutual fund with a NAVPS of $20, and received 50 units, calculated as (amount invested NAVPS) or ($1,000 20). Sam has a marginal tax rate (MTR) of 45%. On December 31, the fund paid out a capital gains distribution of $5 per unit when the NAVPS was still $20. This had the effect of reducing the NAVPS to $15 or ($20 - $5). Sam then held 50 units worth $15 each for a total of $750 or ($15 x 50) plus a pre-tax capital gains distribution of $250 calculated as (number of units x amount of distribution per unit) or (50 X $5). Sam's pre-tax wealth is still $1,000 but it is split between $750 worth of mutual funds and $250 in capital gains. However he will be required to pay tax on a taxable capital gain of $125, calculated as (amount of distribution x inclusion rate) or ($250 X 50%). At an MTR of 45% this will be $56.26, calculated as ($125 x 0.45). Consequently, despite the fact that he has only held his units for one day, he will have to pay tax on the gain that was earned over the course of the year. After tax, his wealth has dropped to $ or ($1,000 - $56.25) IFSE Institute

13 Sam should have waited until January 1, when the NAVPS dropped to $15. He could then have invested his $1,000 and received units, calculated as ($1,000 15). By delaying his purchase he would have avoided paying $56.25 in tax. An investor should avoid purchasing units of a mutual fund near the end of the year if the fund will be paying capital gains dividends. Waiting until January 1 of the following year to purchase shares will ensure there is no unnecessary capital gains tax paid. Example: Capital Gains Through Distributions On January 5, last year, Alison invested $5,000 in Fund YAZ, outside her RRSP, at an NAVPS of $12. She paid a front-end commission of 3%. With mutual funds, the investment is used to pay for funds as well as the sales charge. Her ACB per unit was $ , calculated as [(NAVPS (1 - sales charge)] or [($12 (1 -.03)]. Her investment of $5,000 purchased units, calculated as (investment ACB per unit) or ($5,000 $ ). In December of last year, Fund YAZ was trading at $15 when it declared a capital gains distribution of $2 per unit. The fund price subsequently dropped by the amount of the distribution to $13. The distribution was worth $808.34, calculated as (distribution per unit x number of units held) or ($2 x ). The distribution would be automatically reinvested at the new NAVPS. This provided her with more units, calculated as (distribution NAVPS) or ($ $13). Even though the distribution was reinvested automatically, for tax purposes, Alison is deemed to have received it and must pay tax on it. The entire $ distribution was classified as capital gains. She will have a taxable capital gain of $404.17, calculated as (capital gains x inclusion rate) or ($ x 50%). She will apply her MTR to this amount to find out how much tax she owes. After the distribution she had a total of units or ( ). With the reinvested distribution, her ACB per unit has changed. Since the NAVPS was higher than at her initial investment, you can expect that the ACB per unit will have risen. Her new ACB per unit is $ or $12.45, calculated as (total investment total units) or [($5,000 + $808.34) ( )] Note: You may want to use the following table to help you calculate ACB per unit. transaction cost ($) units ($) ACB ($/unit) purchase 5, distribution , Case Study: Soraya Kumar - Part One Capital Gains through Redemptions When you redeem units of your mutual fund for a profit you realize a capital gain. For tax purposes, capital gains and losses are the difference between the proceeds of a disposition (also called the fair market value or FMV) and the adjusted cost base (ACB) IFSE Institute 13

14 Recall our previous example with Alison and her YAZ Fund units. After her purchase and distribution, she holds a total of units with an ACB per unit of $ She recently redeemed 250 units when the NAVPS was $14. The FMV of her redemption is $3,500, calculated as (NAVPS x units redeemed) or ($14 x 250). The ACB of her redemption is $3,112.50, calculated as (ACB per unit x units redeemed) or ($12.45 x 250). Therefore her capital gain from the redemption is $387.50, calculated as (FMV - ACB) or ($3,500 - $3,112.50). This leaves her with a taxable capital gain of $ or ($ x 50%). Another way to calculate her capital gain of $ is [(NAVPS - ACB per unit) x units redeemed] or [( ) x 250]. A summary of Alison's activity in her YAZ holdings is shown in the following table. Note: Redemptions do not affect the ACB per unit; only purchases and reinvested dividends do. transaction cost ($) units ($) ACB ($/unit) purchase 5, distribution , redemption 3, , Case Study: Soraya Kumar - Part Two Capital Gains Refund Mechanism Mutual funds don't pay tax directly. They are known as "flow-through" entities that distribute all of their taxable income to investors. This avoids paying taxes at the trust level, which is the highest marginal rate. When an investor redeems mutual fund units, he or she realizes a capital gain equal to the difference between the market value of the units at the time of redemption and the adjusted cost base of the shares. The capital gain is subject to tax. However, the market value for the fund units may be attributable to an increase in value of the underlying investments held in the fund. Because the value of the underlying investments rises, so does the NAVPS, allowing the unitholder to sell his or her units for a profit. The fund itself has not yet sold the underlying investments. Thus the increase in the NAVPS of the fund is due to the unrealized capital gains of the investments held by the fund. Once the fund eventually sells these securities and realizes the capital gains, the capital gains flow through to unitholders as distributions. The unitholders must then pay tax on the capital gains distributions. This means that tax is paid twice on these gains: first by the unitholder who redeems the units for a profit and then by the unitholders who share in the realized gains through a distribution by the fund. The capital gains refund mechanism allows the fund to offset a portion of its realized gains in the year. It may retain the capital gains (instead of having them flow through to investors) and obtain a refund of the tax that it would otherwise have to pay. Mutual funds use a formula set out in the Income Tax Act to calculate how much of a mutual fund's realized capital gains may be kept in the fund (i.e., not distributed) without attracting tax, and the optimal amount of capital gains to distribute to shareholders. Exercise: Capital Gains IFSE Institute

15 Capital Losses A capital loss arises when the proceeds of disposition or fair market value (FMV) minus disposal costs are less than the adjusted cost base (ACB). In 2004 Jerome purchased 100 units of the Distant Future Canadian Bond Fund for $12 per unit or a total cost of $1,200, calculated as ($12 x 100 units). He paid no commission on the purchase giving him an ACB of $1,200. Last year, Jerome sold the 100 units for $10.50 per unit for proceeds of $1,050 and paid commission of 4% or $42, calculated as ($1,050 x 4%). His capital loss would be $192 or: FMV = $1,050 Less ACB = ($1,200) Less Commission = ($42) Capital Loss = $192 Allowable capital losses Capital losses are also subject to the 50% inclusion rate. When a capital loss is incurred, for tax purposes it is multiplied by 50% resulting in an allowable capital loss. In the example above, for tax purposes, Jerome will have an allowable capital loss of $96, calculated as ($192 x 50%). Allowable capital losses may be used by a taxpayer to offset taxable capital gains. Net Capital Losses You can only apply allowable capital losses against taxable capital gains, not against other sources of income. To the extent that the allowable capital losses in a given year exceed the taxable capital gains for the year, a net capital loss will arise. In other words, in a given tax year, allowable capital losses can only reduce taxable capital gains to $0. However, net capital losses are not lost but can be taken back three years to reduce previous taxable capital gains or may be carried forward indefinitely to reduce future taxable capital gains. In 2010, Terry bought and sold two mutual funds as follows (ignore transactions costs): Fund A Fund Z ACB $2,000 $3,000 FMV $2,500 $2,000 Capital Gain/(Loss) $ 500 ($1,000) Taxable Capital Gain $ 250 Allowable Capital Loss ($ 500) In 2010, Terry can reduce his taxable capital gain to $0 and he will be left with a net capital loss of $250 or ($500 - $250). From a transaction he did in 2008, Terry has a taxable capital gain of $100. He could use his net capital loss to reduce that to $0. He would then have a net capital loss of $150 or ($250 - $100). This net capital loss could be carried forward indefinitely to offset any future taxable capital gains incurred. For example, if in 2012, Terry incurred a taxable capital gain of $400 he would be able to use his net capital loss carryforward to reduce that to $250 or ($400 - $150). Exercises: Losses 2010 IFSE Institute 15

16 Superficial Losses To prevent the abuse of the deductibility of allowable capital losses, the Income Tax Act disallows the deductibility of an allowable capital loss where the identical item is repurchased by the taxpayer (or his or her spouse) within 30 days of the sale. At the end of last year, Derek realized a taxable capital gain of $1,000 on the sale of XYZ European Equity Fund. Derek also owned 500 units of ABC Japanese Equity Fund that had an ACB of $10 per unit and a fair market value of $5 per unit. On December 6 last year, Derek sold 400 units of the ABC Japanese Equity Fund and triggered a capital loss of $2,000 or (($5 - $10) X 400) and an allowable capital loss of $1,000 or ($2,000 X 50%), which he planned to apply against his taxable capital gain. Nine days later, On December 15, Derek's wife Juanita purchased 400 units of the ABC Japanese Equity Fund for $5 per unit or $2,000. Since his wife repurchased the same funds within 30 days of the sale, Derek is not permitted to use the $1,000 allowable capital loss. Summary: Capital Gains and Capital Losses Mutual fund investors may realize capital gains or losses on their funds. There are two ways investors may realize a capital gain but only one way they can realize a capital loss. Capital Gains Capital Losses investor sells units/shares of mutual fund x x fund manager makes a distribution x n/a Trisha purchased 100 units of Alpha Canadian Dividend Fund for $14 per unit on January 1. Later that year, on March 4, she decided to sell the units when the NAVPS was $20. Ignoring transaction charges she has triggered a capital gain of $600 or (($20 - $14) x 100) and a taxable capital gain of $300 or ($600 x 50%). The fund distributes capital gains If the fund manager decides to sell fund investments and triggers a capital gain, that gain will be flowed through to the investor who will report it for tax purposes. On December 30, the Triumph European Equity fund had an NAVPS of $15, which included $5 in capital gains that the fund manager had realized over the course of the year. On December 31, the fund distributed the $5 per unit of capital gains to unitholders. Charles owned 100 units of the fund and therefore received $500 in capital gains ($5 x 100). Charles will be required to report $250 or ($500 x 50%) in taxable capital gains. Capital losses The only way to realize a capital loss on a mutual fund is for the investor to sell units/shares. On September 12, Uma purchased 100 units of the Polar Canadian Bond Fund for $11 per unit. On October 31 of the same year, she sold the units when the NAVPS was $9.50. Uma triggered a capital loss of $150 or (( $11) X 100) and an allowable capital loss of $75 ($150 X 50%). She can use this to offset taxable capital gains. If the fund manager had sold fund investments and realized a capital loss, that loss would be kept inside the fund and used to offset capital gains realized by the fund. Return of Capital (Capital Dividend) Occasionally, a fund may make distributions to unitholders that are greater than the amount of income and capital gains earned by the fund in that year IFSE Institute

17 When this happens, the excess distribution is considered a return of capital to investors. In effect, some of the money you have invested in a fund is being paid back to you. This amount is not taxed when you receive it. Instead, this amount will reduce the ACB of your units. When you eventually redeem your units, your capital gain will be greater (or your capital loss smaller) than it otherwise would have been without the capital dividend. If the capital dividend reduces your ACB to a negative amount, you are deemed to have realized a capital gain for tax purposes equal to the amount of the negative ACB. In essence, you have received more than you invested and therefore have a gain that will be taxed. A capital dividend will be reflected on your monthly or quarterly statement, but will not be recorded on the T3 slip issued by the fund. Nikos paid $1000 to purchase 100 units of High Peaks Fund at a price of $10.00 per unit. At the end of the year, the fund paid a distribution of $0.60 per unit for a total amount of $60, calculated as ($0.60 x 100). The distribution per unit consisted of $0.24 in dividends from taxable Canadian corporations, $0.30 as interest income, and $0.06 as a return of capital. The return of capital reduced the adjusted cost base of Nikos' fund by $0.06 per unit, to $9.94. When the fund is sold, the lower cost base would increase the amount of the capital gain by $0.06 per unit. Taxation of Distributions to Corporate Unitholders Although individual taxation is a major concern for a mutual fund salesperson, you should also be aware of the different tax consequences for corporations. Similar to individual investors, income distributed from the mutual fund to corporate unitholders maintains its identity. However, the tax rates applied to these types of income differ in the case of corporations: The federal corporate tax rate is different from the tax rate for individuals. The provinces and territories also apply their own specific corporate tax rates. Let's examine how the various types of income are taxed in the hands of a corporation. Capital gains and losses Capital gains and losses for corporations are reported as income in the same manner as for individuals. However, there are no taxable capital gains exemptions available for corporations. Dividends from Canadian corporations In general, tax law enables dividends to flow through public corporations to other public corporations tax-free. However, in the case of private corporations, investment dividends are only tax-free if they are flowed through to the shareholders. Taxation of Non-resident Investors Income distributions from a mutual fund trust that are paid to a non-resident of Canada are generally subject to a 25% withholding tax, although this rate may be reduced by tax treaties with individual countries. For example, withholding tax on payments from a mutual fund trust to U.S. residents is only 15%. The tax must be withheld by the fund and remitted to the Receiver General on behalf of the nonresident investor. All distributions paid to non-resident unitholders from a mutual fund trust, with the exception of capital gains, are subject to withholding tax. These distributions are considered to be income earned by the mutual fund trust, rather than income passed through to investors in its original form. Therefore, a uniform withholding rate is applied to all distributions IFSE Institute 17

18 Capital gains realized upon the redemption of units of a mutual fund trust by a non-resident are generally not subject to Canadian income tax. Mutual Fund Switching In most circumstances, switching from one mutual fund to another triggers a deemed disposition for tax purposes. Subsequently, a capital gain or loss is calculated from the deemed redemption. The fair market value is equal to the proceeds from the deemed disposition of the investment at the time of the transaction. The adjusted cost base is calculated in the same manner as if the mutual fund were redeemed. The resulting capital gain or loss is then subject to the same tax treatment as other capital gains or losses. Exercise: Mutual Funds and Taxes Lesson 4: Personal Income Tax Welcome to the Personal Income Tax lesson. In this lesson, you will learn how to apply your tax knowledge to calculate and compare the tax on various investment transactions. It is important to understand the tax implications to inform your clients of any investment strategy you recommend. Remember, that as a mutual fund representative, you are not expected to provide detailed tax counselling, nor will you be qualified to do so. When such advice is called for, refer your client to a chartered accountant or other tax professional. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following: describe the impact of investments on an investor's personal income tax perform basic tax calculations recommend the best strategy based on tax Tax Efficiency Tax is an integral part of any investment strategy. As a mutual fund representative, you must understand your client's tax situation and how your recommendations can impact their personal income tax. Since there is different tax treatment for the various types of income, it is possible to arrange a portfolio to be more tax efficient. In general, income that does not have preferential tax treatment, such as interest income, should be held in registered plans as much as possible. Income with preferential tax treatment, such as dividends and capital gains, should be held in nonregistered plans as much as possible. As well, some funds can be tax efficient themselves. They have low turnover (or trading) in their portfolio, which postpones the realization of capital gains. Note: Before recommending any tax or investment strategy, ensure that you are aware of all the tax implications involved. Example: Tax Efficiency Here is an example of how tax implications affect investment decisions. Maria holds a bond fund and a stock index fund in a non-registered account. She wants to contribute one of these funds to her RRSP, where it will be sheltered from tax. From a tax efficient point of view, which one should she contribute? IFSE Institute

19 Maria's bond fund generates mostly interest income, which if held in her non-registered account, would be fully taxable. Alternatively, her index fund generates dividends and capital gains, which receive preferential tax treatment. Furthermore, the index fund does not have a lot of trading in the portfolio, which means that capital gains are minimized. Therefore, Maria should contribute the bond fund to her RRSP. Note: When making any contributions to an RRSP in kind, there may be a tax consequence arising from the contribution. Case Study: Vladimir Smirnoff Case Study: The Newmans Case Study: Molly Gibson Case Study: John Smith How Did You Do? As you have just learned, there are many income tax implications for investors. This section was designed to give you a general understanding of how to perform those tax calculations that are applicable to mutual fund investors. If you have had some difficulty with the calculations, we encourage you to go back and review this lesson. Lesson 5: Mutual Fund Corporations Welcome to the Mutual Fund Corporations lesson. In this lesson you will learn about the taxation issues with mutual fund corporations. Remember that as a mutual fund representative, you are not expected to provide detailed tax counselling, nor will you be qualified to do so. When such advice is called for, refer your client to a chartered accountant or other tax professional. This lesson takes 10 minutes to complete. At the end of this lesson, you will be able to do the following: identify the tax consequences of mutual fund corporations About Mutual Fund Corporations Although most mutual funds are structured as unit trusts, mutual funds can also be formed as corporations. Unlike a unit trust, a mutual fund corporation must file a tax return and pay tax on its investment income. Then it must make additional filings with the tax authorities to retrieve the tax paid and enable it ultimately to flow the income through to investors. Although this process is quite onerous for the mutual fund corporation, this refund mechanism works well for dividends and capital gains. However, there is no tax refund available for taxes paid on interest, foreign income, or capital of the fund IFSE Institute 19